Boil down the complexities to avoid costly errors in your clients' estate plans.

Sooner or later, every estate planner comes face to face with the generation-skipping transfer tax (GSTT). Many practitioners do not feel up to the challenge because this particular tax has a reputation for being as treacherous as the sea. But after you boil down all the complications, you’re left with a fairly direct set of circumstances to watch for. This article is meant to help you identify situations that subject clients to the generation-skipping transfer tax and advise them appropriately.

The GSTT is the government’s defense against an end run around estate and gift taxes. It imposes a flat tax on gifts and bequests above the estate/lifetime gift exclusion that avoid gift or estate tax by skipping one or more generations, such as to grandchildren. It is relatively straightforward in its provisions, but financial advisers need to be aware of recent and ongoing changes in exemption amounts, allocations and tax rate and the corresponding implications for estate plans. One important planning element is the optimal use of the lifetime exclusion in tandem with the annual gift exclusion, along with other common estate planning mechanisms.

REINING IN LIFE ESTATES

The GSTT is a simplified version of a tax originally instituted in 1976. Back then, Congress explained that the tax was designed “to remedy the perceived abuse of using a trust to benefit several generations while avoiding Federal Estate Tax during the term of the trust.”

Here’s the abuse they saw: Wealthy families were going to estate planners who created a life estate in their assets for their kids, followed by a life estate in the assets for their grandkids, followed by a life estate in the assets for their great-grandkids and so on. Since life estates are not subject to the federal estate tax, these plans effectively moved incredible amounts of wealth from generation to generation without any risk of the estate tax. Less wealthy families were paying more in estate tax than more wealthy families, who could afford to engage in sophisticated estate planning. The initial GSTT that Congress created, however, was so widely criticized that the Tax Reform Act of 1986 retroactively repealed the 1976 version and implemented the current version.

The 1986 Act imposed a tax equal to the highest estate tax rate on any generation- skipping transfer, with a $1 million exemption per taxpayer. In 1995, the exemption was indexed for inflation in $10,000 increments. In 2001, the exemption was increased to match the estate tax exemption. This change, along with scheduled increases in the exemption amount culminating in the scheduled repeal of the estate and GST taxes, was included in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).

Currently, a taxpayer’s GSTT exemption is $3.5 million, and both the GSTT and the estate tax are scheduled for repeal in 2010. The 2001 EGTRRA changes are then scheduled to sunset on Jan. 1, 2011, and the estate and GSTT exemptions drop back to their 2001 levels, as indexed for inflation. The Obama administration and some in Congress, however, have indicated their desire to avoid repeal of the estate tax and preserve the exemption at its current level. Although they have not specifically addressed the GSTT, it is considered likely to be included in any upcoming estate tax changes (see sidebar, “Forecasting the Estate Tax,” below).

The EGTRRA also introduced another significant GSTT change. Prior to the EGTRRA, a taxpayer’s GSTT exemption was automatically applied only to direct skips. After the EGTRRA, the exemption will also be automatically allocated to indirect skips (defined below) in certain circumstances unless the taxpayer (or the taxpayer’s executor) elects out of the automatic allocation rules. Automatic allocation to indirect skips under the EGTRRA is limited, though: The transfers must be in a GST trust (one that fits the criteria of IRC § 2632(c)(3)(B), which prevents allocation to most charitable trusts as well as trusts in which non–skip persons essentially have more than 25% of the beneficial interest) that’s subject to the gift tax and an estate tax inclusion period that ends after the EGTRRA’s effective date. This automatic allocation is also scheduled to sunset with the other EGTRRA provisions. It is unclear whether it will be retained, but if it is, strategies for electing out under these circumstances, in addition to direct skips, could well be valuable beyond next year.

Forecasting the Estate Tax

About a half-dozen bills in Congress address in various ways the repeal of the estate tax, scheduled for 2010, and its resurrection the following year under 2001 law. The most salient proposals, however, presuppose that the estate tax will remain at 2009 levels, that is, with a lifetime exemption amount of $3.5 million and maximum tax rate of 45%. Tucked away in President Barack Obama’s budget plan for fiscal 2010, which begins in October 2009, is a footnote explaining that a 10-year baseline that otherwise would continue the 2001 and 2003 tax cuts presupposes maintaining the estate tax “at its 2009 parameters.” Likewise, the Statutory Pay-As-You-Go Act of 2009 (HR 2920) passed by the House on July 22 assumes the 2009 estate tax exemption and rates will be maintained going forward and their effects exempted from the pay-go rules.

For better or worse, none of these proposals mention the GSTT. In fact, little attention has been paid to the GSTT in the debate over the estate tax. It may be that because of the tentative nature of the proposals thus far, and because the GSTT affects far fewer taxpayers than the estate tax does, language specifically linking the GSTT to the estate tax, as Congress has usually done, will come later—but probably not too much later, given the looming deadlines. There remains a chance that, even if the 2009 levels are maintained for 2010, they won’t be there for long. The exemption could return in 2011 as currently scheduled to $1 million (adjusted for inflation to about $1,350,000), with a 55% tax applying to all GSTT transactions.

STRATEGIES FOR EXEMPTION ALLOCATION

The GSTT comes into play whenever a donor gifts assets to what the tax law calls a “skip person.” Such a transfer skips one or more younger generations to a person related to the transferor by blood, marriage or adoption. Grandchildren and great-grandchildren are the most common skip persons. But under the deceased parent rule (IRC § 2651(e)), descendants are moved up to their parent’s level if the parent dies before the date of transfer. Thus a grandchild who might be a skip person to his or her grandparent will not be treated as a skip person if his or her parent dies before the grandparent. An unrelated person is a skip person if he or she is more than 37½ years younger than the transferor.

A trust is a skip person in two circumstances: (a) All of the beneficial interests of the trust are held by skip persons, or (b) no current beneficial interests are held by skip persons, but no distributions can be made to “non–skip persons” (the term for anyone who isn’t a skip person). A person has a beneficial interest in a trust in two circumstances:(a) He or she has a present right to income or principal, or (b) he or she is a permissible income or principal recipient (for example, there are no current mandatory income or principal beneficiaries, and the trustee has the right to sprinkle income or principal to a group that includes the person in question).

DIRECT SKIPS

A direct skip is a transfer directly to a skip person. A grandparent writing a check to a grandchild is the most obvious form of direct skip, but direct skips also happen at death. An outright bequest to a skip person counts. Direct skips are the easiest to spot, and a taxpayer’s GSTT exemption is automatically allocated first to these transfers (unless he or she opts out of this). Luckily, there is an annual exclusion from GSTT that also protects any gift that qualifies for the annual gift tax exclusion (currently $13,000 per donor or, if combined by a married couple, $26,000).

Taxpayers who make any direct skips in excess of the annual exclusion must report all GSTT direct skips (including the annual exclusion) on Part 2 of Schedule A of Form 709, United States Gift (and Generation- Skipping Transfer) Tax Return.

TRANSFERS IN TRUST

Transfers in trust are more complicated. They can occur in two ways: by a taxable distribution from a trust to a skip person, or a taxable termination. The latter occurs when an interest in a trust terminates, unless (a) only non–skip persons receive the trust assets, and (b) no skip persons have a right to receive the assets after the termination.

The inclusion ratio is the key to the GSTT on transfers in trust. First, establish a ratio based on the amount of the GSTT exemption allocated to the trust assets. The numerator is the amount of the GSTT exemption allocated to the trust, and the denominator, generally, is the value of the property transferred to the trust. The resulting ratio is then subtracted from 1 to establish the inclusion ratio. An inclusion ratio of 0 means no part of the interest in trust is subject to the GSTT; a ratio of 1 means the entire interest is subject to the GSTT; and a ratio in between means that percentage of the interest is subject to the GSTT.

ALLOCATING GSTT EXEMPTION TO TRUSTS

The GSTT exemption is best leveraged to prevent subsequent additional estate taxes. Allocating exemption to a trust that will bypass the estate tax when a client’s children die and then provide benefits for other beneficiaries produces a much bigger planning bang than simply moving assets to the children’s estates (where they will be subject to the estate tax). To do this, taxpayers must opt out of automatic allocation to direct skips so their exemption is preserved for taxable distributions or taxable terminations, which are known as indirect skips.

Opting out is a two-step process. First, taxpayers must address their direct skips. If they make only direct skips in a year, they can preserve their exemption by reporting the direct skips and allocating none of their GSTT exemption to them (on Form 709, Schedule C). As a result, they’ll pay the applicable GSTT on direct skips.

Second, they must address their indirect skips. If they make only indirect skips in a year, they report them on Part 3 of Schedule A of Form 709, and that’s the end of it. Since those transfers are not yet subject to the GSTT, all that the donors are doing is creating a paper trail. But if they make both direct and indirect skips in a year, then they report the direct skips on Part 2 of Schedule A, report the indirect skips on Part 3 of Schedule A, and then allocate their exemption only to the indirect skips on Schedule C. Again, the bottom line is that they’ll end up paying the applicable GSTT on direct skips and preserving their exemption for indirect skips.

Ultimately, the GSTT is payable when a taxable distribution or taxable termination occurs. Taxable distributions are reported to skip persons by a trustee on Form 706-GS(D-1), Notification of Distribution From a Generation-Skipping Trust, which notifies the recipient of the value of the distribution as well as the trust’s inclusion ratio. The skip persons are responsible for then filing Form 706-GS(D), Generation-Skipping Transfer Tax Return for Distributions, on which the GSTT is calculated. Taxable terminations have a less complicated reporting system. The trustee reports the termination, the value of the property subject to the termination, the trust’s inclusion ratio and the tax due on Form 706-GS(T), Generation-Skipping Transfer Tax Return for Terminations.

LATE ALLOCATIONS

Allocation of the GSTT exemption should be made on a timely filed gift or estate tax return. “Timely filed” means the return is submitted by its due date, including any extensions. When allocations are made timely, they are based on the value of the transfer as of the date of transfer. The IRS allows late allocations, but there’s a price. Late allocations are based on the value of the transferred assets as of the date of allocation, which really means the value as of the first day of the month the return is filed. This can cause a very different inclusion ratio, but that isn’t always a bad idea. If assets depreciate after the transfer, then the taxpayer uses less exemption to cover the transfer. Of course, the assets could appreciate after the transfer, in which case more exemption is needed than would have been necessary on a timely allocation. In a worst-case scenario, a taxpayer would not have enough GSTT exemption to cover a transfer fully if the allocation is late.

ALLOCATION IN LIVING TRUSTS AT THE FIRST DEATH

The following are a few common examples of transfers in trust that have GSTT implications:

First, consider a married couple with an AB trust, that is, one that creates only a bypass trust and a survivor’s trust (see Exhibit 1).

Upon the first death, let’s say of the husband, assuming his GSTT exemption is intact, his assets are transferred to the bypass trust. Usually, the survivor, the wife in this example, is the only person with an interest during her lifetime, and the assets pass to any children and/or grandchildren upon her death. In this case, the husband’s executor would allocate his GSTT exemption to the bypass trust on his federal estate tax return. Since the GSTT exemption matches the estate tax exemption right now, whatever remains in the bypass trust after the wife’s death can pass in life estate form to his or their children (as either current or discretionary recipients of income and/or principal) and then to grandchildren (skip persons) without any fear of causing GSTT as a result of either a taxable distribution or a taxable termination.

Suppose a married couple has an ABC trust, that is, one that creates a bypass trust, a qualified terminable interest property (QTIP) trust and a survivor’s trust, and the husband dies after making outright lifetime gifts of $500,000 to his children (see Exhibit 2).

These gifts would have reduced the amount of his estate tax exemption, but they would not have used any of his GSTT exemption. As a result, only $3 million is transferred to the bypass trust, and the balance of his assets goes to the QTIP trust. After allocating $3 million of the husband’s GSTT exemption to the bypass trust (fully protecting it), his executor still has $500,000 in GSTT exemption available. In this case, his executor should consider a reverse QTIP election. Normally, the survivor will be treated as the transferor of the QTIP trust assets when she dies. A reverse QTIP election, however, means that the husband will be treated as the transferor and his GSTT exemption can be allocated to the assets. By making this election, the husband’s unused $500,000 GSTT exemption can be allocated to QTIP assets, leaving the wife’s GSTT exemption available for other purposes.

A reverse QTIP election is made on the first-to-die spouse’s timely filed estate tax return. Once it is made, it cannot be undone. More importantly, such an election means that the first-to-die spouse will be treated as the transferor of the entire QTIP trust. Consequently, it is usually only done where the trustee has authority, under either state law or the trust instrument, to bifurcate the QTIP trust for GSTT purposes—that is, the trustee is able to create both an exempt and a nonexempt QTIP trust.

LIFE INSURANCE TRUST ISSUES

When a taxpayer creates an irrevocable life insurance trust (ILIT) to hold title to life insurance policies outside the reach of the estate tax, GSTT issues should be considered for every transfer to the trust. Fortunately, once a determination has been made, clients will not need to reconsider their approach unless the circumstances change significantly.

If a transfer to the ILIT qualifies for the annual gift tax exclusion, then the transfer may also be exempt from GSTT because of the annual gift and GSTT exclusions mentioned earlier, but will not in every case. Technically, these gifts do not need to be reported on a federal gift tax return if they are the only transfers made in a particular year, but some practitioners encourage the filing of such a return, primarily because it creates an easy-to-follow paper trail.

If a transfer to an ILIT does lead to a taxable gift, then the client must be thoughtful about the GSTT implications. In situations where the trust is not likely to lead to a taxable distribution or a taxable termination, it may be a good idea to file a gift tax return making it clear the taxpayer elects out of the automatic allocation rules. If, for example, the policy is a term policy on only one spouse’s life, the risk of GSTT issues is fairly small—first, because the term policy will likely lapse before either death, and second, because term policies are usually bought as income replacement tools, and the proceeds will likely be used during the survivor’s lifetime.

Don’t forget one special GSTT bonus for term insurance premiums. If a taxpayer makes a contribution to an ILIT and dies before the due date of the gift tax return regarding the contribution, then allocation of just enough GSTT exemption to cover the last premium should protect all of the policy proceeds from the GSTT. Let’s look at an example that shows how allocation of a small amount of GSTT exemption can protect the entire policy proceeds.

Assume that a husband contributes $12,500 annually to an ILIT that owns $2 million of term insurance on his life, that he has always elected out of automatic GSTT allocations for the purposes mentioned earlier, that he makes a premium payment in June of this year, and that he dies before April 15 of next year. His executor can elect to allocate $12,500 of his GSTT exemption on a gift tax return filed next year to cover the contribution. Effectively, the entire $2 million will be exempt from GSTT, and it will only have “cost” $12,500 of his exemption. Compare this to the situation in which the taxpayer allocated GSTT exemption every year for 15 years. The outcome is the same (the proceeds are exempt from GSTT), but the cost is much greater; that taxpayer would have “spent” $187,500 (15 years x $12,500) of his GSTT exemption.

DESIGN MORE COMPLICATED TRUSTS TO AVOID GSTT ALTOGETHER

Complex trusts, such as qualified personal residence trusts and grantor retained annuity trusts, pose the additional problem of the estate tax inclusion period (ETIP). In living trusts and insurance trusts, the GSTT issues are fairly easy to deal with because they don’t surface until the taxpayer’s death. Split-interest trusts, though, are designed to make transfers during a taxpayer’s lifetime, and the ETIP rules complicate this significantly.

Suppose a client creates a qualified personal residence trust that allows him to use the property for a 15-year term. Under the ETIP rules, you cannot allocate GSTT exemption to the transaction until the 15- year term ends. That’s because the property will be brought back into the taxpayer’s estate if he dies during that term, meaning you won’t know what is completely transferred or to whom until the term ends. When the term does end, the amount of GSTT exemption necessary to protect the assets is based on the value of the assets at that time. Remember that one of the biggest advantages to these leveraged techniques is removing appreciation from the tax calculation, but because of the ETIP rules, the generation-skipping transfer tax would be calculated on the appreciated value. What’s worse is that any GSTT due at the end of the ETIP must be reported and paid immediately.

Few clients want to pay GSTT during their lifetimes. For these reasons, many estate planners design more complex trusts so skip persons (usually grandchildren) never have an interest in the trust. That, in turn, often leads to finding ways to provide equalizing benefits to grandchildren.

REDUCING ANXIETY

The GSTT isn’t particularly complicated on its own; it’s the interaction between the several steps that leaves plenty of room for costly errors. With this quick guide, you should be able to pinpoint GSTT issues and work through them without causing yourself—or your clients—too much anxiety.

EXECUTIVE SUMMARY

Despite its fearsome reputation, the generation-skipping transfer tax (GSTT) is straightforward in its provisions and worth the attention of CPA planning advisers, especially in the currently unsettled political climate.

The GSTT is imposed on asset transfers that avoid estate or gift tax and skip one or more generations, such as by a grandparent to a grandchild, or if to an unrelated person, to someone more than 37½ years younger than the transferor. It is imposed on direct transfers and transfers via trust. The tax rate and exemption amount are those of the estate tax.

Electing out of an automatic allocation of the GSTT exemption to direct skips and paying any applicable GSTT is advised for preserving the exemption for the trust’s future taxable distributions or termination (“indirect skips”).

Late allocations may be made, but they may adversely affect the amount of the exemption allocated to trust assets for any transfer under a pre-established inclusion ratio, depending on whether assets have appreciated since the allocation date.

For couples, a reverse qualified terminable interest property (QTIP) election may allow allocation of any remaining exemption amount of the first spouse to die if only a portion of it was allocated to a bypass trust.

Allocations may also come into play for irrevocable life insurance trusts and complex trusts.

Mark E. Powell (mep@albrechtbarney.com) is an attorney specializing in trusts and estates at Albrecht & Barney in Irvine, Calif.

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